Ireland's Fate Tied to Doomed Banks

By

Charles Forelle and

David Enrich

Updated Nov. 10, 2010 12:01 a.m. ET

DUBLIN—With doubts swirling about the solvency of the Irish state in early September, Finance Minister Brian Lenihan summoned a dozen senior government and bank officials to a conference room nicknamed the "torture chamber," a nod to its history as a venue for painful meetings.

For two years, Ireland had poured money on a raging banking crisis, to no avail. Each estimate of the rising price of rescuing Ireland's banks turned out too low. Mr. Lenihan needed to halt the drip-drip of bad news that was leading his country to ruin. "I want a final figure ASAP," he told the group.

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Two weeks later, the estimate came in: Up to €50 billion—nearly $50,000 for every household in the Emerald Isle.

But now, investors are betting the bill could be higher still and could reignite Europe's sovereign-debt crisis. The unpopular government is bracing for collapse, and on Tuesday, Irish government bonds continued a week-long slide to a fresh record low. The debt is judged as risky as Greece's was this spring just before that nation begged for a European Union bailout.

Mr. Lenihan, racing to ease those fears, proposed Thursday shrinking the country's 2011 budget by €6 billion. Proportionally, that's as if the U.S. suddenly eliminated the Defense Department.

Ireland's troubles are Europe's. The 16 euro-zone countries have agreed to guarantee up to €440 billion in loans if any among them is unable to borrow from private markets.

It wasn't supposed to be this way. In October 2008, Mr. Lenihan boasted that his government had devised "the cheapest bailout in the world so far." Ireland's financial regulator pronounced the banks "more than adequately capitalized."

Interviews with dozens of bank and government officials, and an examination of documents released by the Irish parliament, reveal that Ireland misjudged its crisis early on. Desperate to preserve the homegrown banking system, the government—blind to just how sour Irish loans had gone—yoked the fate of the nation to the fate of its banks.

ENLARGE

Along the way, the government was hobbled by faulty information from outside advisers, from a trust-and-don't-verify regulatory culture and from the troubled banks themselves.

The result has been calamitous: Bad loans at five once-sleepy banks have snowballed into an existential threat. The crisis has hammered Ireland's economy and left taxpayers with a bill that will take a generation to pay. Irate Dubliners burned one big bank's ex-boss in effigy and blocked the gates of parliament with a cement truck in protest. Bankers face criminal probes and a parliamentary inquiry.

The miscalculations are severe. In December 2008, the state laid plans to pour €1.5 billion into Ireland's sickest institution, Anglo Irish Bank Corp. Over the next two years, the government upped the figure a half-dozen times, pumping in a total of €22.9 billion. In September, the central bank said Anglo might need as much as €11.4 billion more.

In an email, Mr. Lenihan said the cost estimates announced in September had put an "upper end" on the price of the bailout in order to "eliminate any uncertainty in the market." The cost rose over time in part because "the information provided by the banks was not a true reflection" of the health of their loans. His 2008 comment that the bailout was the cheapest in the world didn't imply, he said, that "there would be no cost to the bailout."

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For a decade, Ireland was the EU's superstar. A skilled work force, high productivity and low corporate taxes drew foreign investment. The Irish, once the poor of Europe, became richer than everyone but the Luxemburgers. Fatefully, they put their newfound wealth in property.

As the European Central Bank held interest rates low, Ireland saw easy credit for construction loans and mortgages. Developers turned docklands into office towers and sheep pastures into subdivisions. In 2006, builders put up 93,419 homes, three times the rate a decade earlier.

Anglo, founded in 1964, spent its first three decades making small commercial real-estate loans. But when Sean FitzPatrick, an ambitious accountant, took the bank's reins in 1986, he opened big offices in London and the U.S. Anglo bankrolled marquee projects, putting $70 million behind the Chicago Spire, planned as America's tallest building.

The party ended in 2008, when the property bubble popped and the global economy tipped into recession. The government remained optimistic; an internal finance-department memo concluded in May that the Irish banking system was "sound and robust based on all key indicators of financial health."

Yet by September, Irish banks were struggling to borrow quick cash for daily expenses. The government thought they faced a classic liquidity squeeze. Ireland—whose hands-off regulator had assigned just three examiners to two major banks—didn't recognize the deeper problem: Banks had made too many bad loans, whose defaults would leave the lenders insolvent.

"Liquidity, not capital, is the main issue in the current crisis," financial regulator Patrick Neary wrote to Kevin Cardiff, a top finance-department official, on Sept. 10. A week later, Anglo executives told government officials that the bank's core business, despite the cash crunch, was healthy: "Loan book remains strong," they said. And Merrill Lynch bankers working for the government advised that another lender, Irish Nationwide Building Society, could absorb any bad loans. (It has since needed €5.4 billion in bailout money.) Merrill and INBS declined to comment. Mr. Neary couldn't be reached for comment.

The warnings grew louder at the end of September 2008. Anglo's depositors were fleeing. At 8:40 p.m. on Sept. 29, a PricewaterhouseCoopers partner working for the government emailed Mr. Cardiff with bad news: Anglo "borrowed €0.9 billion from the Central Bank and do not have any reserves left."

The next morning, Ireland launched the bailout Mr. Lenihan would dub the world's cheapest, guaranteeing every deposit and nearly all debt issued by Irish banks. Dublin hoped that would free others to lend to Irish banks, and Ireland would muddle through without shelling out a dime.

But while that quickly restored cash to the banks, it didn't address the bad loans. Those loans were now very much the government's problem because the guarantee had made it the protector of the entire financial system.

As Ireland copes with the aftermath of a large property bust, it faces a new wave of emigration but also innovation, as a group of architects band together to create a micro economy. WSJ's Andy Jordan reports from Dublin.

PwC was sent to look at the banks' books. It found defaults creeping up. Still, banks insisted they could soldier on unaided. In December meetings with bankers in the fifth-floor boardroom of Ireland's debt agency, the government resolved to act.

Four days before Christmas, the government announced it would buoy Anglo with €1.5 billion in capital. Bank of Ireland and Allied Irish would get €2 billion each.

PwC found that Anglo burnished its financial reports with temporary deposits and had secretly loaned its directors €179 million. Mr. FitzPatrick, the chairman, resigned. Mr. Neary, Ireland's financial regulator, was eased out with €640,000 in severance and a €143,000 annual pension. Mr. FitzPatrick's lawyer declined to comment.

Predictions that the guarantee would stem the crisis soon looked like fantasies. In January, Ireland nationalized Anglo.

The following month, taxpayers put €7 billion into Allied Irish and Bank of Ireland; the government, using PwC's data, had predicted €4 billion weeks before. And PwC missed the mark further. Relying largely on the bank's own data, it estimated Anglo's bad loans might hit €3 billion a year. Today, Anglo has lost about €20 billion and classifies more than three-quarters of its €64 billion in outstanding loans as "at risk" of default. A PwC spokeswoman declined to comment.

On March 6, 2009, Mr. Lenihan met with advisers to bat around remedies. None sounded promising. He turned to Peter Bacon, an economist he'd hired a week earlier, who shocked the crowded room with a figure far bigger than the few billion Ireland had spent. The banks made more than €150 billion of potentially toxic property and land loans, he said. "That's the extent of your problem."

Mr. Bacon suggested the government buy loans from the banks at discounted prices, effectively handing them cash and easing doubts about their viability. By insisting on steep discounts, Ireland would be less likely to lose money on the purchases. On the flip side, bargain prices would trigger losses at the banks—which the government would probably have to patch with more capital. The taxpayer would foot the bill either way, but at least Ireland would understand how big it was.

The approach "has the merit of certainty and clarity," Mr. Bacon argued. But, he added, it would only work if "the projection of the extent of impairment is accurate in the first place."

It wasn't.

A small team at the debt agency, including Mr. Corrigan, the chief, and a top lieutenant, Brendan McDonagh, pulled together a plan for a new entity, the National Asset Management Agency, to buy €77 billion worth of loans for €54 billion, a 30% discount.

Those estimates shaped public expectations about the rescue bill. But they were based on information from the banks, which told NAMA their loans were well collateralized. In early 2010, Mr. McDonagh's team got a rude surprise upon diving into the books.

"We opened it up and said, 'Oh, my God,"' Mr. McDonagh said in an interview. "What they are telling us is not the reality."

The banks had said they had loaned 77% of the value of a property, on average. The other 23%, put up by the borrower, would cushion a default.

The NAMA teams found that banks often piled on "equity releases" that amounted to lending out 100% of the value, and left them fully responsible in a default.

Worse, much of the collateral was shaky. Several times, a developer pledged future profits on other ventures. Many loans were riddled with flawed documentation, leaving banks without solid legal rights to the property they had believed was backing up the loans.

When NAMA disclosed its first round of loan purchases on March 30 this year, the average discount—or "haircut"—was 47%, far above the 30% originally estimated.

"The detailed information that has emerged from the banks in the course of the NAMA process is truly shocking," Mr. Lenihan told lawmakers. But, he added, "we now know the extent of the losses in our banks....This certainty will further boost international confidence in our ability to recover."

He was wrong. NAMA, preparing its next purchases, demanded steeper cuts. Property prices were tumbling, and the agency was under public pressure not to squander money. Once, a banker complained the agency was drastically undervaluing a loan. "You're damn lucky to be able to get the money you're getting," a NAMA official shot back.

In August, when NAMA announced the next round of purchases, the average haircut rose to 56%, again leaving Anglo short of capital. Again, the government wrote a check.

On the afternoon of Sept. 8, Mr. Lenihan, at work despite a diagnosis of pancreatic cancer nine months earlier, convened government officials and Anglo's brass in his latest bid to put a firm figure on the bank rescue's cost. The ground-floor Finance Department conference room where they met was adorned with photos of past ministers. That day, one of them, Anglo Chairman Alan Dukes, was seated across from his own picture.

Mr. Lenihan told the men that Anglo couldn't be kept afloat. He instructed NAMA to calculate the final haircuts quickly. Over the next two weeks, NAMA priced Anglo's loans at a 67% discount, causing the bank to require another €6.4 billion from taxpayers. It said it would take a 60% haircut on the rest of AIB's loans—likely putting the government in control of that bank.

The total capital injected into banks by the government so far: €34 billion, with at least another €12 billion on the way. The bailouts mean Ireland will run a government deficit equal to 32% of its gross domestic product, the highest figure ever in any euro-zone country. Skeptics say a still-sinking property market will next sour residential mortgages, inflating the government tab even more.

Patrick Honohan, Ireland's central-bank governor, says the government is fighting on two fronts. While wrestling with the banks' bad loans, it must repair state finances badly damaged by a deep recession and a swift erosion of the tax base. The bailout bill, he says in an interview, "is not Ireland's only problem."

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